1 Taxes and Caps as Climate Policy Instruments With Domestic and Imported Fuels

This paper develops a global model of climate policy, focusing on the choice between tax and cap-and-trade solutions. We assume that the world can be split into two regions, with two fuels that both lead to carbon emissions. Region A consumes all fuels, and is responsible for defining and implementing climate policy. Region B produces all of fuel 1 (oil), while fuel 2 (interpreted as either coal; natural gas; or renewables) is both produced and consumed in region A. We study three model variants. All involve full policy coordination within each country block, but no coordination across blocks; and all involve an optimal producer tax on fuel 1 by region B. In model 1, region A sets two fuel consumption taxes, one for each fuel. The optimal region A tax on fuel 1 then exceeds the Pigou level as defined by the region; while the tax set on fuel 2 is Pigouvian. Presence of a second fuel in region A reduces region B’s optimal tax on fuel 1. In model 2, region A sets a common carbon tax, which is lower (higher) for fuel 1 (2) than in model 1. In model 3, region A sets a carbon emissions cap. This enhances region B’s strategic position via the trade-off between fuels 1 and 2 in region A, following from the cap. In realistic cases, this leaves region A strategically weaker under a cap policy than under a tax policy, more so the less carbon-intensive the local fuel (2) is. In conclusion, a fuel-consuming and -importing region that determines a climate policy, will typically prefer to set a carbon tax, instead of setting a carbon emissions cap. The main reason is that a tax is more efficient than a cap at extracting rent from fuel (oil) exporters.